Finance for Nonfinancial Managers, 2nd Ed., by Gene Siciliano.

April 6, 2017

Book Review

The life cycle of a successful company progresses through periods of rapid growth, slow growth, no growth, decline, and demise.  An adaptable company may endure with successive cycles of renewal, rebirth, and resurgence.  This book describes a pathway to success.  Finance is a sub-theme; other themes are accounting and management.

Accounting

A general ledger of all transactions is used to prepare all financial reports and assess the company’s performance. Companies that issue publically traded stock are required to publish 3 financial statements every quarter of the fiscal year. They are:

  1. Balance sheet
  2. Income statement
  3. Cash flow

The Balance sheet is a snapshot of the company’s financial condition at the end of the fiscal period. Items are reported under headings that conform to this equation:  Assets = Liabilities + Equity.  Assets and Liabilities are subdivided into Current and Long-term transactions. Current transactions are expected to be completed in the next 12 months and indicate the company’s liquidity. Long-term transactions indicate the company’s leverage, plus more. Equity is the company’s net worth. Within this framework, the author explains and discusses items of special relevance to business management.

The Income statment describes business operations during the time period between 2 balance sheet dates. According to rules for accrual accounting, every transaction has an order date and delivery date. Subtotal transactions are grouped under revenues, production, operations, other transactions, and net income. Net income (i.e., company profit) is the bottom line of accrual accounting in the Income statement. Readers of this chapter learn how to evaluate the business and its managers.

More businesses fail due to the lack of cash than the lack of profit. Consequently, it’s important that the Cash Flow statement reports a net cash balance from the net cash flows of operations (CFO), investing (CFI), and finance (CFF). The CFO is derived from Net Income (in the Income statement) by excluding non-cash transactions listed in the Income statement such as depreciation, receivables, pre-paid expenses, inventory, and payables.

Finance and Management

The remaining chapters are devoted to these topics:

  • Key performance indicators (KPIs) for evaluating financial statements.
  • Cost accounting, the analysis of manufacturing productivity.
  • Finance of new projects by previewing the return on investment (ROI), weighted cost of capital (WACC), and internal rate of return (IRR). Never invest in a project that has a negative IRR.
  • Breakeven point, to determine such things as the price of a product’s launch and risk assessment.
  • Creating a business plan to guide business operations and attract financial resources.
  • Annual budget, part of the business plan.
  • Financing the company by getting a loan (debt) or selling shares (equity).
  • Entrepeneurship.

Book review: The Little Book that Still Beats the Market, by Joel Greenblatt

September 28, 2013

(9/30/2013 update: The American Association of Individual Investors tested the performance of the magic formula described in this book. The test results are published in the AAII.com stock screens web site. 4/5/2016 update: A ‘revisit’ is added to General Comments)

about the author

Joel Greenblatt is a celebrity among formula investors for devising the “magic formula” to screen stocks. Greenblatt received his bachelors and MBA degrees from the Wharton School at the University of Pennsylvania in 1979 and 1980. He is the founder and managing partner at Gotham Capital, a hedge fund, and is the author of several books on investing. He is an adjunct professor at the Columbia University Graduate School of Business.

General comments

For the benefit of the reader, Greenblatt attempts to explain to his young son a method for earning profits by investing in a portfolio of 20-30 stocks. His method depends on using a magic formula to select ‘good’, ‘cheap’ stocks for purchase and annual replacement. Greenblatt’s method is designed for ordinary investors who commit to the plan at least 3-5 years. It solves the perennial problem of deciding when and which stocks to trade. As of this year, 2013, Greenblatt provides free access to an updated list of screened stocks on his website.  Shortcomings of the method and book are described at the end of this review.

Revisited in Apri, 2016:  Greenblatt’s book reminds us that buying stocks on pure speculation is likely headed for a loss.  Instead, good buying decisions need research and measurements.  His method is to condense the company’s financial statements to 2 measurements in the belief that earning cash from customers is the key element of a successful business: 1) “Earnings yield” is a measurement of market valuation that shows how highly the earned cash is valued by investors in the stock market; higher is better.  2) “Return on invested capital” is a measurement of management efficiency that shows how much earned cash is derived from the company’s assets; higher is better.  Greenblatt claims that a new basket, every year, of high-scoring stocks will collectively beat the stock market after 5 years.  About 50-60% of the purchased stocks will outperform the remainder of 20-30 stocks in his baskets.  Greenblatt’s method is not designed for dividend reinvestment plans and other long term strategies for buying smaller baskets of stocks.  I’m inclined to believe that more than 2 measurements are needed for making small-basket, multiyear investments.

What is a good business?

Jason was an 11 year old business man who sold sticks of gum at school for a huge profit. Suppose Jason opened a chain of gum stores after graduation from high school and achieved success. Now he wants to sell half the business for $6 million. He plans to split the ownership into 1 million equal pieces, called shares, and sell ½ million shares at $12/share (Jason will keep ½ million shares for himself). Is that a good price for the investor? According to Jason’s income statement from last year:

Gum sales   from 10 stores $10 million
Cost of gum $6 million
Other   expenses (rent, salaries, etc.) $2 million
Profit   before taxes $2 million
Taxes (40%   tax rate) $0.8 million
Net profit $1.2   million  ($1.20/share)

One share costing $12 today earned $1.20 last year. That earning, called an earnings yield, is 10% of share price ($1.20/$12.00 = 10%). The 10% yield is better than a risk-free return of 6%, so the share price seems to be acceptable. Will Jason’s earnings grow? That depends on how well he operates the business. Here’s Jason’s return on capital:

Cost of   property and equipment (capital) $4 million
Profit   before taxes (return) $2 million
Yearly return on capital 50%

Jason’s 50% return on capital is better than if he invested $4 million in U.S. government bonds for a risk-free return of 6%. He has a very good business. Good businesses attract competition that may eventually reduce profits. Until then, a high return on capital for one year shows temporary success and reflects a competitive advantage. Warren Buffet, a stock market master, buys stocks of good businesses at bargain prices that show signs of growth in value over time.

Stock Market Master

The stock market master earns higher returns than otherwise earned from risk-free U.S. government bonds (assume the minimum U.S. government bond rate is 6%). The classic method is to buy stocks of good companies at bargain prices. Benjamin Graham was a stock market master who invested with a “margin of safety” by paying less than the company was worth. Graham, who knew that market prices fluctuate according to moods of pessimism and optimism, sold his holdings when an optimistic market was paying more than the company was worth. The success of Graham’s method depended on the availability of many bargains during the era of the Great Depression. Today, very few stocks fit Graham’s requirements.

Greenblatt claims that a revision of Graham’s method will beat today’s market, and future markets, with low risk to the investor. His revision, called the magic formula, is to buy stocks of profitable companies when they are trading at low prices.

Magic formula

All businesses need working capital and fixed assets for successful operation. So, why not rank businesses on the effective use of those assets? The magic formula ranks stocks according to two criteria: return on capital and earnings yield –Greenblatt defines the earnings yield and return on capital differently from the generally used inverse of the price-to-earnings ratio (E/P) and the return on assets (ROA)–.

Good companies have high returns on capital; the higher, the better. The return on capital should exceed the return from a risk-free investment; otherwise, the company is better off investing in the risk-free U.S. government bond. Stocks with high earnings yields offer bargain prices, and higher yields are better bargains. The earnings yield should also exceed the return from the risk-free U.S. government bond.

A stock market index measures the average price of the average stock, but the magic formula selects the above average stock at a below average price. Therefore, it’s a good bet that a basket of magic formula stocks will beat the market. To test this bet, Greenblatt created a portfolio of 30 top-ranking stocks among 3,500 U.S. stocks screened by the magic formula. He used a 3-step screening process: First, all stocks were ranked from 1 (highest return on capital) to 3,500 (lowest return on capital). Second, the same stocks were ranked from highest to lowest earnings yield. Third, the combination of scores were ranked from best to worst (e.g., a ranking of 385 (232 + 153) was better than a ranking of 1,151 (1,150 + 1)). The test portfolio was replaced with a new set of top-ranked stocks every year during the 17 year period of 1988-2004. The market value of the test portfolio grew by 30.8% per year compared to the 12.4% annualized growth of the S&P 500 index. Greenblatt created other test portfolios derived from 2,500 U.S. stocks with market caps above $200 million and 1,000 U.S. stocks with market caps above $1 billion. Both test portfolios grew by 23.7% or 22.9% per year depending on the stock universe.

Did the magic formula make a few lucky picks? Greenblatt opined that a few lucky picks could not bias the outcome.

Will bargain stocks eventually disappear? Greenblatt divided the universe of 2,500 U.S. stocks into 10 subgroups of 250 stocks according to the magic formula’s rankings (i.e., the first subgroup had the highest rankings and the last subgroup had the lowest rankings). The first 6 subgroups of highest ranking stocks (a total of 1,500 new stocks each year) outperformed the S&P 500 during the 17 year test period, indicating a plentiful supply of bargain stocks.

Did subgroup returns correlate with subgroup rankings? It seems so since the returns from subgroup 1 beat the returns from subgroup 2, and so on; however, Greenblatt did not report the correlation.

What if everyone uses the magic formula? Greenblatt opined that they won’t. New participants eventually quit at the first sign of short-term bad news (most investors want to own the most popular stocks, but the magic formula finds less popular stocks!).

What is the risk of losing money over the long term? The good news is that the plan doesn’t lose money and always beats the market during rolling 3-year periods (rolling refers to the calculation of a previous time period every month).

Conclusions

The magic formula offers high returns at low risk based on the simple logic of screening stocks based on the earnings yield and return on capital. The earnings yield helps to sort the universe of stocks for companies that earned a lot last year compared to today’s stock market price. The return on capital is used to identify companies that earned a lot last year compared to the cost of operating the business. The advantage of using the magic formula is to screen for a number of undervalued stocks on a regular basis.

The disadvantage of the magic formula portfolio is the demand for frequent, long-term attention. There are repetitive screenings, many trades, and numerous tax records.  The portfolios described by Greenblatt have a 100% turnover that incur 2 trading fees per stock per year. Since the book does not discuss the potential impact of trading fees on investment return, I estimated the effect of trading fees (see chart) on one of Greenblatt’s test portfolios.  Don’t expect high returns unless you invest at least $15,000 in the portfolio.

magicformualcost

Click on the following links for additional book reviews: 1. A listing of returns from this and other formula investing plans.  2.  Why You Should Take Joel Greenblatt’s ‘Magic Formula’ Stocks Seriously.  3. video, What’s Joel Greenblatt’s Magical Investing Formula?

Joel Greenblatt. The Little Book that Still Beats the Market. John Wiley & Sons, Inc. 2010.


Book review: The Richest Man in Babylon, by George S. Clason

January 5, 2013

George S. Clason. The Richest Man in Babylon. Penguin Books, New York  © 1955, .., 1926.

In 1926, author George S. Clason published a famous series of pamphlets on thrift and financial success that were distributed by financial institutions to millions of readers.  His book is a collection of inspiring parables about personal finance.   It’s a book of “cures for lean purses”.  Here’s a revised summary.

Laws of building wealth

Arkad was a wealthy, generous merchant, but his friends in youth either failed to learn the laws of building wealth or didn’t observe those laws.  Arkad cautioned Bansir, the craftsman, that people who inherit wealth tend to spend it away or live the miserable life of a miser.  For those without an inheritance, acquiring wealth requires time and study.

  1. Save 10% of earnings to create an estate
  2. Put the savings to work by investing in good opportunities
  3. Seek good advice for investing
  4. Losses and gains depend on the skill and experience of the investor
  5. Avoid schemes to earn wealth quickly

People who wait are less fortunate.  Begin investing at a young age.  When Basir asked Arkad’s advice on starting late in life, Arkad repeated the same rules, emphasizing to invest savings with greatest caution not to lose any returns.

Seven cures

Ancient Babylon sat on arid desert next to the Euphrates River.  All of Babylon’s wealth was man-made in this harsh environment.  Work was not reserved for slaves, it was also the friend of freemen.  There was a time when very few rich citizens acquired most of the gold while the rest of the population lived in poverty.  The King desired that all men should know how to acquire wealth so he consulted Arkad, the richest man in Babylon.  Arkad agreed to train teachersabout the 7 cures for an empty purse:

  1. Save 10% of your income
  2. Avoid needless expenses for luxuries.  Budget for necessary expenses.
  3. Multiply your savings with compounded returns
  4. Invest wisely, where the principal is safe.  Don’t make risky investments.
  5. Own your house
  6. Insure a treasure for retirement and protect your family.
  7. Cultivate skill and wisdom.  Pay your debts and prepare a will.

Making loans

Only lend money to people with good credit.  They will use the loan wisely and repay the loan.  The safest loans are to those who can fully repay by selling property or who have an assured income.  Borrowers who have no property or income need a friend to guarantee repayment.  Hopeless debt is a pit of sorrow.  Is the borrower credit worthy?  How will he use the loan?  Does he understand the business?  Does he have a plan?

Repaying loans

Young Takard was destitute, hungry, and in debt.  One of his lenders, a wise camel trader named Dabasir, confronted Takard with an allegory:  Dabasir was once indebted to many lenders until he determined to repay with income earned by hard, honest work.  Moral: repaying a loan requires determination.

Dabasir’s plan to repay debt was to allocate earnings in this way:

  • 10% into savings account
  • 70% to support the household
  • 20% to repay lenders

Protection of wealth

Ancient Babylonians used a small army to defend against the mighty army of Assyria.  The strong walls of Babylon protected the citizens and their treasures.  Today, we can’t afford to be exposed by inadequate protection.  The impregnable walls that protect our treasures from unexpected loss are:

  • Insurance
  • Savings accounts
  • Dependable investments

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